Market Capitalization

Stocks may be classified by the size of the corporation. This is most commonly done looking at the market capitalization. Market capitalization is simply a measurement found by taking a stock's current share price and multiplying it by the number of stock shares outstanding. Exact market cap ranges will vary among different financial and rating institutions, [1] but there are three different terms commonly used to describe stocks by their general size: Large Cap stocks; Mid Cap stocks; and Small Cap stocks. Market cap terms are relative and are constantly changing as companies get bigger and smaller.

Table 1. Market Capitalization

Size Characterization

Capitalization Range

Large Capitalization Stocks

over $10 billion dollars

Mid Capitalization Stocks

between $2 billion and $10 billion dollars

Small Capitalization Stocks

between $300 million and $2 billion dollars

Capitalization ranges for companies that are smaller than small cap stocks include Micro Cap and Nano Cap stocks.

Table 2. Market Capitalization

Size Characterization

Capitalization Range

Micro Capitalization Stocks

between $30 million and $375 million dollars

Nano Capitalization Stocks

below $50 million dollars

Risk and Returns

US Markets

Beginning with Rolf Banz in 1981 [2] and continuing with Eugene F. Fama and Kenneth R. French in 1992 and 1999 [3], academic studies have found that US Small Cap and US Small Cap Value stocks provided premium returns during the twentieth century. These premium returns were accompanied by greater risk. (See Table 3. and Table 4. below). While US Small Cap stocks provided a 2% premium return over US Large Cap stocks over the twentieth century, Small Cap stocks declined a real -70% over three years during the Great Depression and declined a nominal -90.78% (1929 - 1932) and -53.15% (1972-1974).

Table 3. Historical Returns and Risks of U.S. Stocks in the 20th Century [4]

In addition to a size premium, twentieth century returns showed the presence of a realized value premium. The 1926 - 2000 return of US Small Value Stocks was 14.87% as compared to the 9.92% return of US Small Growth Stocks. [6] Figure 1. shows the growth of a dollar investment in each of the four quadrants of market capitalization from 1927 - 2000. For investors to attain these premium returns required long term holding periods, as the market, value, and size factor returns often rotate over time and there are long periods when portfolio tilts to small and small value stocks lag the market. [7]

The prospective risk premium for Small Cap and Small Value stocks is subject to debate. Reliable future premium returns must be based on compensation for risk, or there is the possibility that, because they are known, they can now be arbitraged. Behavioral economists (see Haugen for a review), have posited behavioral reasons for the historical risk premiums. Others (John Bogle) have expressed doubts as to the viability of the Small Cap and Small Value premium: [8]

"From 1925 through 1964 - a period of fully 39 years - small caps and large caps provided identical returns. Then, in just four years, through 1968, the small-cap return more than doubled the large-cap return. Virtually that entire margin was lost during the next five years. By 1973, small caps were about at par with large caps for nearly the full half-century. The small caps' reputation was made largely during the 1973-1983 decade."[9]

Vanguard index fund returns

Since 1975, investors have been able to index US Large Cap stocks. Since the early 1990's investors have been able to index US Market, US Small, US Small Value and US Small Growth Stocks. [11] The returns of Vanguard funds are provided in the following three tables. Table 5 shows returns in the 1990's, a period dominated by the returns of Large Cap Growth Stocks; Table 6 shows returns in the 2000's, when Small Cap and Value stocks provided premium returns; and Table 7 provides returns over the entire period. The apparent anomaly of higher period (1990-1999) returns for the Vanguard Small Cap Index Fund over its constituent value and growth index returns is due to Vanguard using, until May 2003, the Russell 2000 Index for the Small Cap fund and S&P style indexes for the Small Value and Small Growth Funds. Since May 2003 all three funds have been indexed to MSCI indexes.

In the three year period since the 2008 downturn (2009-2011}, annualized returns for the Vanguard index funds (investor shares) are as follows:

Total Market +15.01%

S&P 500 +14.01%

Small Cap +19.11%

Small Growth +22.20%

Small Value +15.96%

International Markets

UK Small Caps 1955 - 2001

"Using a new dataset of accounting information merged with share price data we find a strong value premium in the UK for the period 1955-2001. The value premium exists within the small-cap as well as the large-cap universe. We also find that dividend yield as a measure of value produces strikingly similar results. The time-series of return spreads between portfolios sorted according to dividend yields closely matches the results obtained from sorts on book-to-market. However, managers attempting to capture the value premium in the small-cap segment should pay particular attention to rebalancing-induced portfolio turnover and market illiquidity in small-value stocks. Compared to the U.S., the U.K. market for small-cap stocks is relatively illiquid. Trading costs are therefore an even more crucial determinant of overall performance. This is likely to be the case in other non-U.S. markets as well."

Research into international stock market performance over the last quarter/half of the twentieth century provided evidence of a realized Small Cap premium. Hawakini and Keim (2000), in a study of 16 international markets [14] found evidence of a small cap premium in 15 of the 16 countries (the exception being Korea, which provided a monthly -0.40% small cap discount). The positive monthly premium ranged from 0.41% in Singapore to 4.16% in Mexico. The data series in the study varied, with most study periods ending in the 1980's to 1990. As Dimson, Marsh, and Staunton report, subsequent to the publication of these findings, the Small Cap premium reversed in international markets during the 1990's. [15] The 2000's have witnessed premium returns for international small cap stocks as evidenced by the performance of MSCI EAFE indexes:

Table 8. MSCI US & EAFE 2000-2009 Returns

Index

1-year

3-year

5-year

10-year

International Large Cap

31.78%

-6.04%

3.54%

1.17%

International Small Cap

42.51%

-9.67%

1.30%

4.30%

US Large Cap

27.80%

-5.06%

1.02%

-0.94%

US Small Cap

36.15%

-4.21%

1.81%

6.21%

Small cap international stocks demonstrated lower correlation to US Large (0.72 vs. EAFE 0.86) and US Small (0.71 vs. 0.76 EAFE) stocks during the 1999-2008 period. [16] The case for persistence in lower correlation for small cap international stocks is the tendency for small cap stocks to be economically tied to local national economies as opposed to being global enterprises.

As is true in US markets, international small cap stocks incur higher transaction costs compared to large cap stocks. Quigley provides transaction cost breakdowns for regional markets.

In addition to Vanguard, Schwab and Dreyfus offer no-load US Small Cap Index Funds. According to IndexUniverse.com, a total of 39 small cap ETFs are currently available. The major ETF managers are included in the table below. One should note that Powershares ETFs are indexed to proprietary quasi-active indexes (the Intellidex and Zacks series).